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Raining Dogs

While the prospect of inflation has been looming for some time -- a natural byproduct of an aging recovery; a slumping U.S. dollar, which makes imported goods more expensive; and soaring commodity prices -- inflation psychology didn't grip the market until the Fed began to worry about it, out loud.

In a companion statement to its seventh quarter-point hike in the benchmark short-term federal funds rate, the Fed's policymaking Open Market Committee warned unexpectedly: "Pressures of inflation have picked up in recent months, and pricing power is more evident." To bond investors, this suggested that monetary tightening may not be as measured as it has been and that rate hikes in half-point increments are possible.

_____1st Quarter Scorecard_____
Research your mutual funds' performance for the first quarter of 2005:
Biggest Funds
Best Performing Funds
Worst Performing
Get More Funds Quotes
_____Mutual Funds Report_____
As Dow 11,000 Fades Further, Inflation Colors Assessments (The Washington Post, Apr 3, 2005)
Waiting for Greenspan (The Washington Post, Apr 3, 2005)
Sector ETFs Allow Investing in Trends (The Washington Post, Apr 3, 2005)
_____Funds Q&A_____
Transcript: Washington Post reporter Ben White was online to answer questions about how inflation worries are influencing stock and mutual-fund performance.
_____Earnings Watch_____
Jos. A. Bank Earnings Rise 31 Percent (Reuters, Apr 4, 2005)
Jos. A. Bank Posts Higher 4Q Profit (Associated Press, Apr 4, 2005)
Service Corp Sees Earnings Fall (Associated Press, Apr 1, 2005)
Best Buy to End Rebates, Reports Earnings (Associated Press, Apr 1, 2005)
Best Buy to End Rebates, Reports Earnings (Associated Press, Apr 1, 2005)
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_____The Markets_____
Dow Over 12 Months
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S&P 500 Over 12 Months

The yield on 10-year Treasury notes has climbed, closing at 4.45 percent on Friday, up from about 4 percent in early February. Until then, despite rising short-term rates, longer-term interest rates had barely budged, and some had even declined, defying history and confounding financial professionals.

What's Next for Investors

At this stage, some experts say, the major fault line between winners and losers has a lot to do with whether companies are on the right side of some acceleration in inflation and interest rates. And, they add, the market is not without opportunities.

Gint Rimas, a senior analyst who tracks Wall Street's earnings forecasts for Thomson Financial, said analysts are estimating that earnings for companies in the S&P's 500-stock index will rise 10.9 percent this year, up slightly from the 10.5 percent they were forecasting at the end of 2004. That includes an estimated gain of 13 percent for companies in the troubled technology sector.

Rimas said the biggest shifts in expectations have been for energy and consumer-oriented companies. At the end of last year, analysts thought energy company earnings would fall 4 percent in 2005. Now they're projecting an 11 percent gain. Conversely, while at year-end analysts thought earnings for consumer-oriented companies would rise 14 percent this year, now they're forecasting half that gain, or only 7 percent, largely reflecting poor prospects for the large U.S. automakers coping with faltering demand and massive pension obligations.

Friedman, Billings, Ramsey's MacKenzie thinks the oil service companies -- beneficiaries of stepped-up oil company spending -- are well positioned for the current environment. Oil closed Friday at $57.27 a barrel, and his firm expects oil prices to average $44 a barrel this year, though he, personally, thinks that figure is conservative.

"The market is nowhere near discounting the earnings growth that's possible for drilling companies over the next two years," he said.

In Siegel's view, an inflationary environment gives growth stocks an edge over value stocks. That's because dividend income plays a larger role in value stocks' returns, which means they will compete more directly with the higher yields available on bonds. Growth stocks' prices are more affected by potential price appreciation.

And investors could do worse than to consider the views of a group of institutional money managers recently polled by Russell Investment Group. According to Randy Lert, the firm's chief portfolio strategist, the investment managers queried for the Investment Manager Outlook Poll think the markets are in the midst of a major shift -- so they're abandoning their three-year infatuation with small-cap value stocks and embracing large-cap growth stocks.

"The major takeaway for investors is that managers believe the environment that has favored small- and mid-cap value-type stocks is changing. The catalyst for change may be a spike in long-term interest rates," he said. According to Lert, money managers think the actual turning point may come when the 10-year Treasury note's yield rises to 5 percent.

"So they're now buying growth-oriented stocks of companies whose earnings are less connected to the broad economic environment and interest rates." He added that relatively low valuations for large-cap growth stocks may also be driving this enthusiasm.

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